Investment Risks All Investors Should Understand

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When it comes to investing, risk is par for the course. Acknowledging and understanding the risks your investments face is a key first step in ensuring your portfolio is designed to conform with your risk tolerance, investment objectives, and peace of mind.

There is really no such thing as a totally “risk-free” investment – not if you are expecting a return that is above the “risk-free” rate of return i.e. more than the return you get from investing in a Treasury Bill. Risk is part of everyday life, and your investments are no different.

Risk/Return Tradeoff

The concept of risk in finance is based on the degree of uncertainty surrounding an investment and its expected return. Risk is the possibility that you may not get your expected return (gain/profit) and may even lose your entire capital.

The risk-return trade-off infers that the higher the perceived risk of an investment, the higher the return investors seek as compensation for taking on that risk. The lower the perceived risk of an investment, the lower the expected return. When someone tells you that an investment generates a very high return but has a very low risk, be sure to look more closely because their assertion is unlikely to be true.

To recap: Higher Risk = Higher Expected Return

For example, stocks are generally considered riskier than bonds or Guaranteed Investment Certificates (GICs), and historically have earned higher returns than other more conservative assets.

Let’s discuss some of the risks investors face:

1. Market Risks

This is the risk that your investments will react to market or economic conditions which are not known beforehand, and which can have a positive or negative impact. Market risks are also referred to as systematic risks – they are difficult to control, affect the general financial markets, and cannot be entirely diversified away.

Some of the factors that pose market risks include: interest rates, inflation, exchange rates, regulations; geographic, economic, and political factors. I will discuss each risk individually.

2. Interest Rate Risk

This is a risk faced by fixed-income investments like bonds and GICs. When interest rates rise, the price of bonds fall and when interest rates fall, bond prices rise. If a bondholder decides to sell their bond holding before maturity and interest rates have fallen, they risk having to sell their bond at a discount and below face value.

For a security like a fixed-rate GIC, if interest rates rise, your return (interest paid to you) does not change, and you are technically “losing” money for the remainder of the GIC term. This is because your capital could be earning more money if it was not already tied up (opportunity risk).

3. Inflation Risk

Also known as Purchasing Power Risk. Is the risk that inflation erodes the purchasing power of your returns over time. Inflation risk affects fixed-income investments the most. When the inflation rate goes up, income from fixed-income assets (such as bonds, T-bills, GICs, and other cash equivalents) lose value and may even become negative returns. Negative returns occur when the rate of inflation exceeds your investment return.

Some investments are designed to account for changes in the inflation rate and interest rates will rise in line with inflation. Commodities like gold do well during inflationary periods.

4. Currency/Exchange Rate Risk

Investing in international securities is a key part of the portfolio diversification process. However, it also exposes you to foreign currencies and foreign exchange risk. Depending on how the foreign currency performs against your “home” currency, your investments may gain or lose.

5. Socio-Political Risks

Unexpected social or political upheavals can affect your investments. Changes in government or regulation, social unrest, war, terrorism, unemployment, natural disasters, governments taking over publicly-traded companies and nationalizing them, etc. can significantly disrupt business activities in a country and hamper the ability of companies to make a profit and pay dividends (for example).

6. Economic Risks

National or global economic events such as economic booms and downturns can affect the overall financial market irrespective of the type of investment. An example is the financial crises of 2007-2009 which led to depressed economies and markets worldwide.

7. Credit/Business Risk

This is also known as Default Risk or Business Risk. Investors who own fixed-income securities (bonds, GICs, preferred shares) face credit risk because a bond issuer (borrower) may become unable to meet their obligations to pay interest when due or even to return principal at maturity. Credit rating agencies like Standard and Poor’s, Moody’s, and Fitch rate bonds to reflect the creditworthiness of the issuer and risks faced by investors.

Stockholders feel the brunt of credit risk when a company goes bankrupt and creditors are paid out first. If all company assets are depleted after paying off bondholders and preferred shareholders, investors who own common shares may lose some or all of their investment.

Additionally, a business may fail for several reasons including poor management, obsolete products, increasing competition, loss of a “star” executive, or industry sector decline, leaving investors with a loss of capital/return.

8. Volatility Risk

Is the risk that asset prices will fluctuate up and down due to factors beyond your control. Frequent and drastic changes in the price of a stock make investors nervous and prone to making wrong moves that can cost them dearly, such as selling stocks when prices bottom and buying them at the top.

Volatility tends to bring out the worst in investors and is one of the triggers to the many behavioural biases that present themselves in times of market turmoil.

9. Liquidity Risk

This is the risk that an investor may not find a ready market to buy or sell an investment.

For example, if you want to dispose of a stock and the market for that stock is thin or illiquid, you may be forced to sell the stock at a discount to entice buyers or may even be unable to find any willing market participants. A very liquid stock or market allows for the timely purchase/disposal of an asset without significant changes in price.

10. Re-Investment Risk

Is the risk that when your investment matures, you will have no choice but to reinvest at a lower rate of return.

For example, if your bond investment matures and you want to reinvest your principal, but interest rates have fallen, you will have to reinvest at a lower interest rate.

11. Concentration Risk

Is the risk you face when you concentrate your money in one company or investment asset. A 100% exposure to a single asset class increases your risk of total loss. Concentration risk is mitigated by owning a well-diversified portfolio containing multiple investments or asset classes.

Managing Investment Risk

As already mentioned, risk is a basic ingredient in the recipe for all investments. However, the level of risk you expose your investments to can to an extent be managed. Risks specific to a company (credit/business risks) can be easily diversified away, while systematic risks (inflation, interest rates) cannot be fully eliminated.

Here are some time-tested strategies to manage your investment risks:

A. Diversification

A diversified portfolio basically means you do not put “all your eggs in one basket.” Diversifying your investment portfolio means owning investments that cut across different asset classes, industry sectors, countries, etc. For example, having a mix of equities and bonds in your portfolio, including those with global coverage.

When assets are not 100% correlated, chances are that when some are performing poorly, others are doing great. This lowers the overall volatility and risk of the portfolio.

B. Asset Allocation

Within your diversified portfolio, assets are held in different proportions relative to your risk tolerance, investment time horizon, and investment objectives.

For example, an aggressive investor who has a high tolerance for investment risks may have a portfolio with assets allocated as: 90% Equities and 10% Bonds. Because they are aiming for a high return (high equities %), they can also expect to face greater volatility and risk and should not panic when this is the case.

This same asset allocation would not work well for an investor who prefers to take moderate risks/volatility and would be better suited with a balanced portfolio (for example 50% Equities and 50% Bonds).

Understanding your risk tolerance and investment objectives is a major part of risk management.

C. Portfolio Rebalancing

Over time, your asset allocation would change due to assets performing/growing at different rates. It is important to periodically (at least once a year) assess your portfolio and rebalance the assets back to their target weightings.

The act of rebalancing is great for keeping your risks at levels you are comfortable with, and also helps you to buy more of assets that are cheaper (under-performing) and sell off some units of assets that have done well.

D. Think Long-Term

Financial markets do their own thing!! Investing for the long term is a great strategy to manage everyday investment risks. There will always be fluctuations in asset prices, maybe even prolonged periods when prices stay depressed. However, in the long term, asset prices often bounce back and continue their upward run.

Stay cool-headed when everyone else is selling and the proverbial “sky is falling.” In some cases, this is the best time to buy more. In the longer term, the patient investor usually comes out on top.

E. Keep It Simple, Stupid

Invest only in what you understand. If you don’t feel comfortable, seek financial advice.

There are numerous financial products and securities that investors can access nowadays, however, not all of them are suitable for the average investor. Complicated derivatives and exotic assets are not for the average Joe – remember, the higher the expected return, the greater the risks you are taking. Complicated actively managed investments also come with higher fees.

Consider simple solutions like index funds and ETFs that are adequately diversified and are likely to generate close to market returns at a low fee. Another more recent and simplified approach to take when looking to lower your investment fees is to use Robo-Advisors.

Very good summary about the investment risks. In order to get decent returns, we investors have to take some of the risks. As long as we understand the risks, and have enough time horizon to recover from the loss if any, I guess it should be okay. Have a good weekend.

@Helen: You summarize my points perfectly. Yes, investment returns and risk go hand-in-hand. As long as an investor invests according to their risk tolerance and investment objectives, they should be fine. Odds are that a patient investor will come out on top in the long-term.